UNIT 3 DETERMINANTS OF INTEREST RATES

Structure
3.0 Objectives 3.1 Introduction 3.2 Pure Interest and Gross Interest Rates 3 . 3 Bond Price and Yield to Maturity 3.4 The Term Structure of Interest Rates 3.5 Factors Affecting Market Interest Rates 3.6 Effects of Changes in Interest Rates 3.7 Let Us Sum Up 3.8 Key Words 3.9 Some Useful Books 3.10 Answers/ Hints to Check Your Progress Exercises

3.0 OBJECTIVES
After studying this Unit, you will be able to: Explain the concepts, like pure and gross interest rates, bond price etc., Summarise the important theories of term structure of interest rates, Identify the factors influencing market interest rates, and Describe the effects of changes in interest rates,

INTRODUCTION
Borrowing and lending in the financial market depend to a significant extent on the rate of interest. In economics, interest is a payment for the services of capital. It represents a return on capital. In other words, interest is the price of hiring capital. Capital, a s a factor of production, takes the form of machinery, equipment or any other physical assets used in production of goods. On the other hand, funds must be made available to the entrepreneurs for buying these physical assets. Purchase of capital assets i s called investment and funds made available for the purchase of such capital assets is called financial capital. Some persons have to supply this financial capital to the entrepreneurs who would use it for investment in real capital assets. The payment to those who supply financial capital for its use is called the market rate of interest. This is expressed a s a percentage of sums of funds borrowed. On the other hand, the entrepreneur who buys capital equipment and uses it in the process of production gets addition to his revenue, which is called return on capital. The return on capital is the addition to production which increases his revenue.

3.2 PURE INTEREST AND GROSS INTEREST RATES

According to Prof. Meyers, interest is the price paid for the use of loanable funds. Different rates of interest are charged for the same sum of loan for the same period because of the fact that some loans involve more risk, more inconvenience and more incidental work. Thus interest is of two types : pure interest and gross interest. The pure interest is the payment for the use of money a s capital when there is neither inconvenience, risk nor any other management problem. Whereas, gross interest is the gross payment which the lender gets from the borrower. It includes not only net interest but also payment for other elements, which have been outlined below.

Dcterminilr~ts of Interest Rates

Elements of Gross interest

i)

Payment for risk : Every loan, if not secured fully, involves risk of non- payment due to the inability or unwillingness of the borrower to pay back the debt. The lender charges something extra for taking such risk.

ii) Payment for inconvenience : The moneylender may add extra charges for the inconvenience caused to him. The greater the inconvenience involved, the higher will be such charge and consequently the gross interest. For instance, the borrower may repay at a very inconvenient time to the lender or the borrower may invest the capital for a period longer than the one for which loan has been given. iii) Payment for management : The lender expects to be compensated for the additional work he h a s to do in connection with lending e.g., the form of keeping accounts, sending notices and reminders and other incidental work.
jv)

Payment for exclusive use of money, i.e. pure interest: It is the payment for the use of money which is in addition to payments for the above-mentioned risks, inconvenience and management.

In short, gross interest is the total payment which the lender gets from the borrower, whereas, net interest is just one part of gross interest which is paid exclusively for the use of capital. According to Keynes, interest is purely a monetary phenomenon and its rate is determined by the monetary forces of demand and supply. Interest is the reward for capital and is the payment made to the supplier of capital for the use of this factor in the process of production.

-nan ial

The Basic Syst.em

3.3 BOND PRICE AND YIELD TO MATURITY

Price of a bond moves inversely to the yield to maturity. Therefore, the best approach to predict the bond price is to first know its yield of maturity. The yields of maturity of all bonds are dependent upon market interest rate, which fluctuates frequently. These fluctuations arise from factors which are internal as well a s external to the firm using the funds.

1) Internal Factors :The probability that the investor in bond might suffer from default or bankruptcy of the issuer is called default risk. Default risk is that portion of a n investment's total risk' that result from changes in the financial solvency of the investment. For example, when a company that issues security moves close to bankruptcy, this change in the firm's financial solvency is reflected in the market price of its securities. The variability of return that investor experiences as a result of changes in the credit worthiness of a firm that issues the investment securities is their default risk. Default risk can be further divided into: (i) business risk, and (ii) financial risk.

i) Business risk : It refers to the variability of operating

incomes or earning before interest and taxes. It is influenced by demand variability, price variability and operating leverage. ii) Financial Risk : It represents the risk arising from the use of debt capital. If the firm depends heavily on debt capital, it will have high degree of financial risk exposure.
2) External Factors : These factors affect bonds simultaneously. Change in the supply a n d demand for credit, changes in the macroeconomic environment (also called m a r k e t r i s k ) are factors external to the individual corporations, which affect their bond yield and prices. These factors determine the level and structure of market interest rates, and, thus, bond prices.

i) Purchasing Power Risk An increase in the amount of currency in circulation may result in sharp and sudden fall in its value. Purchasing power risk denotes the fact that an investor's money may lose its purchasing power because of inflation. To understand purchasing power, first, we will see how inflation can be measured. Economists measure the rate of inflation by using Priue Index, which is prepared by government agencies. Such Price Index measures the cost of a representative basket of consumer goods, which include food, clothing, housing and health care products, which are bought by average urban households. Prices of the goods change from
a.

26

month to month. The amount of that change is stated a s a percentage and thus the resultant figure is that of inflation. In other words it is the difference between the price i n d e ~

Determinants of Interest Rates

of a commodity in two months divided b y the price index in the preuious month. Thus, we may call the inflation rate of
the month, which is converted into annual inflation. For example if inflation is 1% then annual inflation will be (1+1.0% per month)12 - (1.01)12 1.1268 + 12.68% The goods which have strong demand will experience faster rate of inflation than the goods that are not in strong demand. ii) Real Return/Nominal Return
I

After inflation is measured, it should be compared to investment return. An investment's nominal rate of return is money rates of return, that is, they are not adjusted for the effect of inflation. Take up 9 numerical problem to understand. We assume that a saving deposit earns a nominal interest rate of 5% during one-year period. Thus, if Rs. 100 are deposited, it would grow to 100 (1 + 0.05) = Rs 105 in a year. If we also assume that rate of inflation is 5% then the real value (in term of current purchasing power) of Rs. 100 saving at end of the year is still 100 after we divide the nominal rate by the inflation rate to get the real rate 100 (1.0 + 0.05/ 1.0 + 0.05)
=

Rs. 100

In this case, the nominal rate of return and inflation rate are same. A wise investor should compare the inflation rate with the nominal rate of return from different investment to see if the investment's real rate of return is positive or negative. lnvestors should focus on real returns so as
,

i)

to avoid being fooled by the money illusion fallacy, and

ii) to detect those investments that will maximize their purchasing power. The saving's purchasing power will not increase even though there will 5 percent more rupees in it. iii) Market Risk Market ups and downs are usually measured by using a Security Market Index. When a security index rises fairly consistently for a period of time, this upward trend is called a Bull Market. The bull market ends when the market index reaches a peak and starts a downward trend. The period of time during which the market declines is called Bear Market. Market risk arises from this variability in market return, which results from the alternating bull and

The Basics of Financial System

bear market forces. The main element that causes the stock market to rise 'bullisthly' and then fall 'bearishly' again and again, is the fact that the nation's economy follows a cycle of recessions and expansions. Market yield to maturity are determined by many things. The most basic determinant of interest rate is what economists call the real rate of interest, or the rate a t which capital ' grows in the physical sense. In addition to the real rate of interest, market interest rate are also affected by various risk premiums which investors may demand. In order to undertake risky investments, lenders may requisite one or more risk premiums to be paid over and above the real rate of interest to induce them to lend their funds when the risk of loss exist. Since the interest rates and loans are typically in nominal money quantities, rather than real physical quantities, the nominal interest rate must contain a n allowance for the rate of price changes so that lender's wealth is not be croded away by inflation. Level of interest rate is determined by

Nominal or market = real rate of interest + various interest rate possible risk premium + expected rate of return
Although, the rising rates of inflation push up the interest rate, but sometimes, changes in interest rates are not related to inflationary factors but, are result of various risk premiums, changes in supply of and demand for loanable funds. During a period of economic expansion, the unemployment rate falls, business activity quickens and business needs more money finance for purchase of machinery and to build bigger plants. This results into higher interest rate. In contrast, during slowdowns and recession, unemployment increases, manufacturing activity slows and demand for credit decreases. This results into fall in interest rate, if all other factors are constant. The oombined effect of changes in inflationary expectation and changing credit market conditions causes the level of market yield to vary over a wide range from year to year. Any bond issuer usually has, on any given day, different yield to maturity on its various bond issues, which will differ in terms of maturity. For a given bond issue, the structure of yield for bonds vary with different terms to maturity, but no other difference is called term structure of interest rate. When two bonds are alike or nearly so in all respects except time to maturity, they usually set a t different yielld because of the difference in their maturities. The relationship between

yield and maturity is known a s term structure of interest rate. A plot of this relationship is known as yield curve The level of inflatiohary expectations and the phase of business cycle are two of the main factors, usually affecting interest rates. But various kinds of risk premiums, which rise and fall, can also have a n important effect on market interest rates. iv) Yield Spread A yield spread is the difference between the promised yields on any two bond issues or classes of bonds. Yield spread may also be called risk premiums because they measure the additional yield that risky bonds pay to induce investors to buy more-risky bonds, rather than less risky bonds. Yield spread, other than spreads between different maturities are caused' primarily by difference in risk and taxability, but they are also influenced by anything that affects the supply of and demand for various kinds of bonds. Risk premiums are higher when economic conditions are not favourable. During recession, fear of job loss and risk aversion are higher. Therefore, most investors demand large risk premiums to induce them to buy risky bonds. Secondly, the corporation which issues bonds, typically experiences reduced sales and profits during recession: Since the issuers are more subject to bankruptcy during recession, investors require larger risk premiums. Thirdly, the daily qale and purchase of bonds by bankers and investment managers have a substantial impact on yield spread. Most of these financial experts scrutinize the political developments, which have economic financial implications. When a country is involved in a war, it usually spends more on war. Most governments finance their deficits by printing new money which results into inflation which exerts harmful effects upon the economy of the country.

Determinants of Interest Rates

Check Your Progress 1

1) What is the difference between Gross Interest and Pure

Interest?

2)

State whether following statements are true or false? i) There is a direct relationship between price of a bond and its yield to its maturity. (T/F) ii) Risk arising from the use of debt capital is known as (TIF) financial risk.

iii) Changes in macro-economic environment does not affect the bond yield and prices. (7'1F)
3) How is the rate of inflation measured?

...........................................................................................

4)

What do you understand by the term Yield Spread?

3.4 THE TERM STRUCTURE OF INTEREST RATES

In addition to changes in the level of interest rate, which arise due to changes in the rate of inflation, unusual risk premiums, changing credit conditions, there are changes, which are termed a s the 'term structure of interest rate'. For a given bond issuer, the structure of yield for bonds with different terms of maturity is called the 'term structure of interest rates'. The term structure of interest rate', or 'yield curve', as it is called, may be defined a s the relationship between yields and maturities of bonds in given default risk classes. The relationship is usually presented graphically a s Yield Curve'. The yield curve changes a little everyday and there are different yield curves for each class of bonds. The yield curve for the riskier classes of bonds are at a higher level than the yield curve for less risky bonds. The difference in levels is due to the difference in risk premium. The yield curves for risker bonds are not so stable. There are two types of yield curves as presented in figure (A) and (B). On the vertical axis in both the figures, 'yield to maturity from a security is drawn, whereas, on the horizontal axis time to maturity is drawn. There is a positive relationship between the yield to maturity and the time to maturity, if yield to maturity increases as, time to maturity increases. This positive relationship between yield to maturity and time to maturity is shown in figure (A), and the yield curve obtained from this relationship is called as 'nornial' yield curve'. The 'normal yield curve' is called so, because it is more common. However, sometimes, the relationship between the yield to maturity and time to maturity is not positive. tThis results in a downward sloping yieid curve (as shown in figure B). This downward, sloping yield curve is known a s 'inverted yield curve'.

Yield to Maturity

Time to Maturity
(A)

Time to Maturity
(C)

/-

Yield to Maturity

I
1

Determinants Interest Rat

Time to Maturity

Normal Yield Curve

Inverted Yield Curve

(B)

Yield to Maturity

Humped Yield Cume

The above-mentioned yield curves are simplified versions of yield curves. In the practical world however, the shape of yield curves is much more complex and sometimes it takes the shape of 'humped curve' [as shown in figure (C)]. There are three theories about how the shape of yield curve is determined.
1 ) The Liquidity Preference Theory

According to Liquidity Preference Theory, lenders prefer short-term securities over long term securities, unless the yield on the longer-term securities are high enough to compensate for the greater interest rate risk. Risk is related to variability of return or dispersion of market value. So interest rate risk increases with term to maturity of a bond. The long-term bonds have more interest rate risk than shortterm bonds because of their long duration and because their interest elasticity is larger. A s a result, the prices of long-term bonds fluctuate more than the prices of shortterm bonds. The large price fluctuations are the basis of liquidity premium hypothesis. Unlike lenders, borrowers show a preference for long-term securities. They (borrowers) will borrow on a relatively shortterm securities only if these are available a t smaller interest rates. Thus, generally, lenders are averse to long-term securities (because of the higher risk involved), and borrowers are averse to short-term securities. These aversions on the part of lenders and borrowers influence the term structure of

The Basics of Financial System

interest rates. However, the term structure on interest rates . is likely to vary over time, as the degree of these aversions varies. Thus, the degree of these risk aversions influences the shape of yield curve also. With a n increase in the risk aversion on either or both the parties, yield curve moves upward and vice-versa. However, Cooper and Fraser (1990) noticed that, liquidity preference, by itself, couldn't account for a downward sloping yield curve. Maturity preferences by the borrowers and lenders, their expectation regarding future yields etc, are other explanatory factors. However, there are other theories, which have attempted to identify these factors. These theories are discussed as follows.
2) Expectations Theory

The Expectation theory hypothesises t h a t investors' expectation alone shape the yield curve. This theory assumes that the yield on a long-term bond is a n average of the short-term yields that are expected to prevail over the life of the long-term bond. Its validity rests on the assumption that investors are indifferent to any variation in risks associated with different maturities. They consider long term and short-term bonds to be perfect substitutes for one another, and, therefore, move freely from one maturity to another always looking for highest expected return. This implies that when all investors expect the rates to i) rise, the yield curve would slope upward ii) remain unchanged, the yield would be horizontal or iii) fall, the yield curve would slope downward.
3) Market Segmentation Theory

Accocding to market segmentation theory, interest rates for various maturities are determined by demand and supply conditions in the relevant segments of the market. Investors are not indifferent to difference in maturities. Instead they have definite maturity preferences, which are based largely on the nature of their business. For example, using the simple arithmetic average if 1" year rate is 10% and it is expected to be 11% next year, then the rate on two-year bond will be approximately 10.5%

If we assume forward interest rate that we expect to exist in 3 year ahead is 15% then bond rate will be approximately 12%

The interkst rates are generally referred to as spot and forward rates. Forward rate refers to yield to maturity for

bond which is expected to exist in future: Whereas, spot rate refers to the interest rate for bond, which currently exists and is being currently bought and sold. Forward rates are implicit. These rates cannot be observed, whereas, spot rates can be observed. This theory is also referred to as 'hedging theory'. The implication is that investors' decisions are typically affected by the particular pattern of their liabilities. Given the maturity of investors' liabilities, he or she can hedge against capital loss in the bond market by synchronizing asset with liability maturities. Thus, each investor remains confined to some maturity segment, which corresponds to his or her liability maturities. Some bond portfolio panagers attempt to increase their portfolios' yield by undertaking a bond investment strategy called 'riding the yield curve'. This strategy may be undertaken whenever the yield curve is upward sloping (that'is the long term rates are higher than the short term rates) regardless of whether the yield curve is smooth or kinky . Riding the yield 'curve is a buy and hold strategy, in which the bond investbr purchases a n intermediate or long term bond when the yield curve is sloping upward and is expected to maintain {his slope and level. The purchased bond is simply held in order to obtain capital gains that occurs as the bond move closer to the maturity date and thus rides down the yield curve. That is in addition to the coupon rate. Bond investor earns capital gains. Of course, danger in this strategy is that the level of interest rates may rise or that the short-term end of the yield curve may wing upward.
A compilation of all these theories furnishes the best

Determinants of Interest Rates

description of the elements of determining the 'term structure of interest rate'.

I.

Check Your Progress 2

1) What do you mean by 'term structure of interest rates? b

2) 'State whether following statement are true or false:

i) According to Liquidity Preference Theory, interest rate increases with term to maturity of a bond. (T/F) ii) According to Expectation T h e o e of Interest, yield on a long-term bond is an average of the short-term yield, expected to prevail over the life of the long-term bond. (T/ F)

r-

The Basics of Financial

System

iii) The yield curve slopes upward in the event of falling yield rates. (7'1F) iv) Market Segmentation Theory of interest stipulates t h a t i n t e r e s t r a t e s for v a r i o u s m a t u r i t i e s a r e determined by demand and supply conditions in thp various segments of the market. (TIF)

3 . 5 FACTORS AFFECTING MARKET

INTEREST RATES
There are many interest rates in the market and they do not always move in the same direction or to the same extent. Therefore, it is sometimes useful to select one rate to represent the short-term market. I t is commonly believed that four factors are dominant in determining interest rate levels. These are state of economy, monetary policy, inflation expectations and federal budget. Three other factors that can be important are: i) Saving by individuals,

ii) International capital flows, and iii) Amount of premium required by investors to compensate for interest rate risk.
1 ) Economic Conditions

Interest rates have a tendency to move u p and down with changes in the volume of business activities. In period of rapid economic growth, business firms require large amount of capital to finance increased requirements of in working capital and fixed asset. The business demand for borrowed funds, combined with increase in consumer borrowing put upward pressure on interest rates.

2) Monetary Policy
Monetary policy refers to the policy measures adopted by the Central Bank of the country such a s changes in rate of interest (i.e, change in cost of credit) and the availability of credit. The policy regarding the growth of money supply also comes under the purview of monetary policy. Changes in bank rate, open market operations, cash reserve ratio of banks, selective credit controls are the various instruments of monetary policy. i) Bank Rate

Bank rate is the rate a t which the central bank of a country provides loans to the commercial banks. Bank rate is also called the discount rate because in the earlier days, the

central bank used to provide finance to the commercial banks by rediscounting their bills of exchange. Through change in the bank rate, the Central Bank can influence the creation of credit by the commercial banks. When the Central Bank raises the cost of borrowing, the bank rate would rise. When bank rate is raised, the commercial banks also raise their lending rates. When the rate of interest charged by commercial banks are high, businessmen are discouraged to borrow more. This would tend to contract bank credit and hence would result in reduced aggregate demand for money. This would reduce prices and check inflation or rising prices. On the other h a n d , by lowering the b a n k rate, the Reserve Bank encourages or induces the commercial bank to borrow more funds from it. This enhances their capacity to make more credit available to the businessmen. ii) Open Market Operations The term 'open market operation' means the purchase and sale of securities by the Central Bank of the country. The sale of securities by the central bank leads to contraction of credit and purchase of securities that leads to credit expansion. When the economy is in the grip of depression, purchase of securities by central bank from the open market is called for. The central bank will pay the price of the securities to the sellers, which are generally the commercial banks. As a result of this, the quantity of cash a t the disposal of commercial banks will go up and they will be in a position to expand credit to the businessmen. With this, the aggregate demand will increase which will help to cure depression. On the other hand, during inflation the central bank sells the securities and thereby contracts money supply. iii) Cash Resenre Ratio (CRR)
A cash reserve is the fraction of total deposits of the banks,

Determinants of Interest Rates

which is required to keep a s deposit with RBI. When RBI wants to contract credit or lending by banks, it raises the CRR. On the other hand, when it wants to increase the availability of credit, it lowers the CRR. iv) Supply of Money One of the primary objectives is to achieve stable economic growth with a low rate of inflation. Generally the faster the I ( gz11 rcserves are allowed to grow, the greater the volume of lending, the fidster the growth rate of money supply. If the supply of money grows faster than the needs of the economy [or a considerable period of time, nominal interest rates will rise due to an increase in the rate of inflation

The Basics of Financial

System

3) Expected rate of Inflation

Purchasing power risk arises from unanticipated inflation. It is the risk that the rate of inflation will be greater than the investor expected when the investment was made causing the real rate of return to be lower than expected. Because of these risks, market interest rates and other required returns include an inflation premium.
4) Government Deficit

Increase in government securities, unless offset by decreases in other borrowing means an increase in the total demand for loanable funds. There is a positive correlation between the amount of government deficit and the money supply:

3 6 EFFECT OF CHANGES IN INTEREST . RATES

The basic argument of interest rate policy is that a rise in the interest rate raises the cost of credit and thus discourages investment a s well a s consumption finqnced with loans. On the other hand, lowering of the rate of interest cheapens t h e cost of credit a n d t h u s encourages investment expenditure a s well a s consumption expenditure. Hence, the interest rate policy can be used a s a contra cyclical measure. A change in the short-term rate of interest can be brought about by changing the bank rate, the rate a t which the ; Central Bank f a . country discounts the first rate shortterm bills of exchange. It is assumed that a change in the bank rate directly influences the rate of interest charged by the comm'ercial banks on their advances, a s well a s the other short-term interest rates, such as those charged for money a t call, bill discounted, hire purchase finance etc. However, the short-term rate of interest is relevant to investment in inventories. A change in this rate is not likely to influence it significantly, as interest cost constitutes only a small part of the total cost. Similarly, it may not affect the consumption facilitated by purchase, provident fund contributions and insurance premium.
:

A change in the short-term rate of interest can effectively change t h e value of credit taking some factors into consideration. This can be explained by a n example o f t increasing short-term rate of interest with a view to control inflationary situation. It will give rise to following difficulties: 1) It will add to the balance of payment difficulties a s current account by increasing the cost of short term borrowing from . abroad.

46

2 ) It will increase the cost.of serving the national debt.

3) It may also tend to pull up the long term rate of interest as people may begin to expect rise in the long term rate of interest, and thus, they may begin to sell long- term securities in consequence of which their prices will fall and long-term rate of interest yielded by them will rise. ;neck Your Progress 3
1) What is bank rate?

Determinants of Interest Rates

2 ) Why are the open market operations resorted by the Central

Bank?

3) What type of relationship exists between amount of ~overnment deficit and money supply?

1) How does the rate of interest influence the consumption and investment?

3.7 LET US SUM UP

Borrowing and lending in the financial market, to a significant extent, depends on the rate of interest. There are four elements of gross interest: payments for risk, payment for inconvenience, payment for management, payment for exclusive use of money. The fourth component i.e. the payment for the use of money is known a s Pure Interest. Price of a bond moves inversely to the yield to maturity. The yield of maturity of all bonds depend upon interest rate which fluctuate frequently. Fluctuations in the bond interest rates are caused by the internal factors namely, default risks, business risks and financial risks, and external factors i.e. purchasing power risk and market risks. Three theories have been promoted to explain how the shape of yield curve

The Basics of Financial System

is determined. These are: the Liquidity Preference Theory, Expectation Theory and Market Segmentation Theory. These theolries have furnished the description of the elements, which determine the term structure of interest rate. Many interest rates are found in the market and they do not necessarily move in the same direction. The reasons behind many interest rates in the market are economic condition, monetary policy, inflation expectation and federal budget. Interest rate significantly influences the investment and consumption. Rise in the interest rate raises the cost of credit and discourages the investment expenditure, a s well as consumption expenditure. On the other side, lowering of interest rate reduces the cost of credit, and thus, encourages the investment and consumption expenditure.

KEY WORDS
Bear Market Boom
: A market in which prices of shares' and commodities are decreasing.
: Refers to a period of expansion of business activity. A boom reaches a

peak when the economy has been working a t a full capacity.

Bond

: A security issued by a Government,

Government agency, or a private company as a m e a n s of raising money.

Bull Bull Market

: A person who expects prices, especially of shares and commodities, to rise.

: A market in which prices are rising enabling bulls to operate profitably.

Depression (Slum) : The stage of trade cycle characterising decreasing prices, output ,I * !d employment and thus, under-ur i I sation of all factors of productiol! Financial Capital
: Funds made available for purc t 1nse of capital assets is called financial capital.
: Inflation refers to a tendency of

Inflation

persistent rise in prices over a period of time.

Yield

: Yield measures the annual income from an investment against its current

market price. Yield falls when prices rise.

: Graph showing the return on fixed

Determinant. of Interest Rates

Yield Curve

interest securities according to their maturity.

3.9 SOME -USEFUL BOOKS

Hendrik, S. Houthakker & Peter, J. Williamson (1996): The Economics of Financial Markets, Oxford University Press, Chapter 6, Page 141-167. Bhole, L,M (1992): Financial Institutions and Markets, Tata McGraw Hill Publications, New Delhi, Chapter 22 Page 447464. Cooper, S. & Fraser, D.R. (1990): The Financial Market Place, IIIrd Edition, Westley Publishing Company, Massachuales, New York, Chapter 7, Page 156-182.

3.10 ANSWERS/HINTS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress 1
1) Gross interest is a wider term. Pure interest is a part of

gross interest which refers to the payment made for the use of capital. Gross payment is the total payment the lender gets from the borrower. 2) (i) False (ii)True (iii) False
3) The inflation is measured by the Price Index prepared by

the Government agencies. 4) See Section 3.4 Check Your Progress 2 1) 'Term structure of interest rates' refers to the structure of yield for bonds with different terms of maturity. 2) (i) True (ii) True (iii) False (iv) True Check Your Progress 3 1) The rate a t which the Central Bank of a country provides loans to the Commercial Banks. 2) A s a measure to cure the depression and inflation. 3) Direct. 4) The higher interest rate raises the cost of credit and thus, discourages investment as well as consumption. On the other hand, lowering of the interest rate cheapens the credit and thus, increases the investment expenditure.